By William Lazonick, New Deal 2.0
Posted on July 25, 2011, Printed on April 9, 2012click here

In 1991, well-known compensation consultant Graef S. Crystal published In Search of Excess: The Overcompensation of American Executives
in response to an explosion in executive pay that occurred in the US in
the 1970s and 1980s. How, Crystal asked, did it make any economic sense
for the CEOs in his sample of 200 large US corporations to be making
130 times the pay of the average American worker? And why were they
making about seven times the compensation of their CEO counterparts at
Japanese companies, many of which were out-competing their US rivals?

Yet the surge in top executive pay
that Crystal observed 20 years ago pales in comparison to the volcanic
eruption that has occurred since then. In the mid-2000s, top executive
pay in the United States was about three times higher in real terms than
the levels of the early 1990s. And the ratio of the average
compensation of the CEOs of the largest corporations to that of the
average worker climbed as high as 525:1 in
2000 before declining to what has become the "new normal" of about
350:1 in 2010. The gains from exercising stock options represent both
the largest and most variable component of top executive pay, giving
CEOs, CFOs, and other top dogs a huge interest in allocating corporate
resources in ways that jack up their companies' stock prices -- most
notably through stock buybacks that can run into billions of dollars per
year.

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Large corporations use buybacks to manipulate the stock market. And
the fact that top corporate executives can sell the shares that they
acquire from exercising stock options without any delay means that,
avoiding any risk, they can capitalize on the short swings in their
company's stock price that their corporate allocation decisions help to
create. Nice work if you can get it! And guess how they got it? A gift
of the regulator of US stock markets, the Securities and Exchange
Commission (SEC).

In 1982 and 1991 the SEC - the US government agency which is supposed
to protect stock-market investors from stock-price manipulation and
short-swing profits by insiders -- promulgated rule changes that gave the
wolves free access to the chicken coop.

Under the Securities Exchange Act of 1934,
large-scale stock repurchases can be construed as an attempt to
manipulate a company's stock price. In November 1982, however, SEC Rule 10b-18 changed
all that. The new rule provided companies with a "safe harbor" that
assured them that manipulation charges would not be filed if each day's
open-market repurchases were not greater than 25% of the stock's average
daily trading volume for the previous four weeks and if the company
refrained from doing buybacks at the beginning and end of the trading
day. Under these rules, during the single trading day of, for example,
July 13, 2011, a leading stock repurchaser such as Exxon Mobil could
have done as much as $416 million in buybacks, Bank of America $402
million, Microsoft $390 million, Intel $285 million, Cisco $269 million,
GE $230 million, and IBM $220 million. And, according to the rules,
buybacks on these scales can be repeated day after trading day.

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Stock-buyback programs -- say, $10 billion over four years -- require
the approval of a company's board of directors. But, with a program in
place, the company is not required to disclose the dates on which
buybacks are actually done (a 2004 amendment to Rule 10b-18 only
requires that a company report in its 10-Q filing repurchases in the
previous quarter, well after the fact). So top executives who make
decisions to do buybacks are privy to inside information that, as
holders of stock options, can be very valuable to them.

Why did the SEC pass Rule 10b-18 back in 1982? According to a Wall
Street Journal report dated November 10, 1982 on the new regulation,
Rule 10b-18 "made it easier for companies to buy back their shares on
the open market without fear of stock-manipulation charges". SEC
Chairman John Shad, who had previously been a top executive at the Wall
Street investment bank E. F. Hutton, was an advocate of the rule change.
He argued that large-scale open market purchases would fuel an increase
in stock prices that would be beneficial to shareholders. One of the
SEC Commissioners, John Evans, argued that as a result of Rule 10b-18,
some manipulation would go unprosecuted. But then he agreed to make the
Commission's vote for the rule change unanimous.

Coincidentally, it happens that November 1982 was the start of what
would be the longest stock-market boom in US history, lasting until the
Internet bubble burst in late 2000. In the process, both stock buybacks
and stock options became the yin and yang of US corporate executives.

As a complement to Rule 10b-18, in 1991 the SEC made a rule change
that enabled top executives to make quick gains by exercising their
stock options and immediately selling the acquired shares, thus avoiding
any risk that the price of the acquired stock would decline before
being sold. Under Section 16(b) of the 1934 Securities Exchange Act
corporate directors, officers or shareholders with more than 10% of the
corporation's shares are prohibited from making short-swing profits
through the purchase and the subsequent sale of corporate securities
within a six-month period. As a result, top executives who exercised
stock options had to hold the acquired shares for at least six months
before selling them.

Treating a stock option as a derivative, however, in 1991 the SEC
deemed that the six-month holding period required under Section 16(b)
was from the grant date, not the exercise date, of the option. Since all
stock options take at least one year to vest from the grant date, the
rule change meant that executives could now immediately sell the shares
acquired by exercising options. The new rule eliminated the risk of loss
between the exercise date and the sale date, and gave top executives
flexibility in their timing of option exercises and immediate stock
sales so that they could personally benefit from, among other things,
stock-price boosts from buybacks.

In 1987, after leaving the SEC, John Shad donated $20 million to
Harvard Business School (HBS) to fund the teaching of business ethics
courses that could curb abuses on Wall Street. HBS subsequently had
difficulty putting that money to its intended use. But it did manage to
spend $20 million to build Shad Hall, an ultra posh fitness center designed especially for executives who attended the School's advanced management courses.

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One does need to stay in shape to do buybacks and exercise options.

William Lazonick is director of the UMass Center for Industrial
Competitiveness and president of The Academic-Industry Research Network.
His book, Sustainable Prosperity in the New Economy? Business
Organization and High-Tech Employment in the United States (Upjohn
Institute 2009) was awarded the 2010 Schumpeter Prize.

B.Com.,
University of Toronto; M.Sc. (Economics), London School of Economics;
Ph.D. (Economics), Harvard University In 1991 Uppsala University
awarded him an honorary doctorate for his work on the theory and history
of economic development.

William
Lazonick is Professor in the Department of Regional Economic and Social
Development at University of Massachusetts Lowell and Director of the
UMass Lowell Center for Industrial Competitiveness. He is also
affiliated with the CNRS Groupe de Recherche en Économie The'orique et
Applique'e of Universite' Montesquieu Bordeaux IV. Previously, he was
Assistant and Associate Professor of Economics at Harvard University
(1975-1984) and Professor of Economics at Barnard College of Columbia
University (1985-1993), and Distinguished Research Professor, INSEAD
(1996-2007). He has also been on the faculties of the University of
Tokyo (1996-1997), Harvard Business School (1984-1986), and University
of Toronto (1982-1983), and was a visiting member of the Institute for
Advanced Study in Princeton (1989-1990). Numerous governmental agencies
and private foundations in Europe, the United States, and Japan have
funded his research. In August 2009, his book, Sustainable Prosperity in the New Economy?: Business Organization and High-Tech Employment in the United States, will be available from the Upjohn Institute for Employment Research.